Smart-factor investing will help investors: Edhec

Smart beta investing needs to go one step forward to help investors build diversified portfolios of passive funds, a research paper from French business school Edhec has found.

The 96-page academic paper, Risk Allocation, Factor Investing and Smart Beta: Reconciling Innovations in Equity Portfolio Construction, said conventional stock market indices are market-cap weighted, so performance is often skewed towards the largest stocks on the index.

Although smart beta – such as creating an index based on dividends or earnings – can provide a “partial answer” to the main shortcomings of market-cap weighted indices, the study claimed investors would benefit from a “smart-factor index”.

It said: “This works by constructing indices that explicitly seek exposures to rewarded risk factors and diversifying away from unrewarded risks”. This is done largely through stock selection and calculating the risk/reward profile of each stock.

According to the study: “The results we obtain suggest that such smart factor indices lead to considerable improvements in risk-adjusted performance.”

Background

Last year, Cass Business School released research that suggested retail investors and pension funds would be better served by investing in smart beta funds than in pure market-cap weighted indices. However, while some advisers already create portfolios of passive funds for their clients, some thought that smart beta might be one step too complicated for many retail investors. Duncan Glassey, principal of Edinburgh-based Wealthflow, said: “While I like using this sort of additional beta and think you can get a better return from it, I do get nervous when people develop sexy solutions and say this is the next best thing.”